borrowing from 401K

skinut2234July 18, 2006

I have need to pay for some repairs on auto and house I cannot afford to wait- I just do not have $$$ in budget right now. I have a decent amount in my 401K and was going to borrow about $2500.00 from it - I know there is some penalty in doing this- What are the pros and cons.... isn't it already my money and can I not repay via a paycheck deduction??? Can someone explain in plain terms since I get confused easily when talking about money. My employer allows us to borrow against our 401K

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Suze Orman posted a column recently about emergency funds on yahoo. There's some good text in it that might help you think about this decision:

    Bookmark   July 18, 2006 at 9:58AM
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Well, the money you borrow isn't going to be earning the same as the rest of your money. Even though the interest is paid to your account, it won't be as much as the regular earnings, provided you have a good 401K account.

Secondly, if your employment terminates, for any reason, you have to immediately pay back the loan. Can you do that if you are no longer employed?

Have you checked with your bank or mortgage holder to see if they have a no-cost HELOC you can open?

    Bookmark   July 18, 2006 at 10:28AM
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How fast can you pay it back?

Here's another article:

Here is a link that might be useful: borrowing from 401K

    Bookmark   July 18, 2006 at 10:28AM
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You can borrow up to 50% of your vested 401k account up to $50,000.

I believe the major drawback of borrowing from your 401k is that you miss out on the compounding of interest. There's no actual penalty other than that provided you pay it all back. You pay yourself back with automatic monthly payments over 5 years with interest (the interest is to yourself as well). Now, I believe that if you're not earning much in that 401k, its not so bad.

If the choice is between borrowing from your 401k or a credit card with 20% interest, then I'd go the 401k. But, ideally you should start saving an emergency fund for these kind of things.

I didn't check the link to Suze's page, but I know she's dead set against this. I think sometimes she's a bit harsh. JMO.

Here is a link that might be useful: Smart Money

    Bookmark   July 18, 2006 at 10:36AM
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You have to pay income tax on the money you withdraw, so add whatever your income tax rate is to that $2500. For me, it would be higher than my credit cards. And if you're close to the next tax bracket, that could send you over the edge.

Money invested into your 401k is pre-tax. But the loan you repay into the 401k comes out of your paycheck AFTER taxes, so you also pay income tax on the amount you repay. You basically get double taxed. There is an exception for education expenses but you have to prove that the money went for education.

    Bookmark   July 18, 2006 at 2:18PM
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You don't need to pay taxes if you are borrowing the money.

For a short term emergency, it's a reasonable option. My advice is do it this one time and then start a top priority savings plan to make sure that you accumulate at least 6 months worth of expenses in a relatively liquid form. You should try very hard not to get yourself into a situation where you can't take a $2,500 surprise without borrowing.

    Bookmark   July 18, 2006 at 8:22PM
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Rather than taking money OUT of your 401K, I wondered about using it as collateral for a loan; you aren't using the funds directly, you are simply leverageing a portion of them to secure a loan... failure to repay what you've borrowed would incur drastic penalties, but dire circumstances extract dire promises... how we "own up" to those promises defines our character. Maybe I'm missing something really important here?

    Bookmark   July 18, 2006 at 10:01PM
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Well, I doubt you could pledege an exempt asset as collateral...

Maghane ... you do not have to pay taxes on money that you borrow from a 401k unless you elect not to repay the loan.

I understand the reasoning not to borrow from a 401k but think in some situations it makes more sense than borrowing money at a high rate of interest.

    Bookmark   July 19, 2006 at 1:49AM
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If a loan from a 401K is repaid within 5 years, there are no tax implicaitons. If it is not repaid, then it is considered an early distribution and is taxed as ordinary income and a 10% penalty is added. Now, it is not always easy to get a loan from a 401K. That depends on your plan.

    Bookmark   July 19, 2006 at 4:23PM
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I don't understand "exempt asset". (I don't have a 401K so I don't know how they work). Could someone please explain this to me?

    Bookmark   July 21, 2006 at 4:00PM
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In the context that it was written, I imagine that it means that it is something that the bank can't take from you even if you default on the loan. If that's the case, then it can't meaningfully be pledged as collateral for a loan.

In normal circumstances, no one can force you to give up certain assets even if they get a judgment against you. Retirement savings, life insurance policies, some home equity, and the tools of your trade are some things that are typically covered. There are exceptions. The bank can take your house if you don't pay your mortgage.

    Bookmark   July 21, 2006 at 11:20PM
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Thanks for the clarification, Jose.. I didn't know so many things were "off limits" in the event of a default! It never crossed my mind that an asset you "own" couldn't be put up as collateral in part or in total.

Something sticks in my mind that you can borrow against a life insurance policy... I seem to recall my father telling me that he did that, but that was a long time ago and perhaps the rules have changed in the years hence. I'll have to check into what the options are for the policies we have.

So much to learn!

    Bookmark   July 22, 2006 at 10:04AM
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